Purchasing power parity and long-term currency valuation
Use absolute and relative purchasing power parity and the real exchange rate to judge long-term currency valuation, and understand why PPP is a poor timing tool.
What you will learn
- The difference between absolute and relative purchasing power parity (PPP).
- How to calculate a PPP rate, a valuation gap and a real exchange rate.
- How inflation differences shift the PPP rate over time.
- Why PPP helps with long-term context but is not a trading signal.
Explanation
How inflation is measured (CPI, core and headline) was covered in the course "Macro" (lesson "Inflation: CPI, Core vs Headline, Real Returns"). This lesson connects inflation with exchange rates.
Absolute PPP
Purchasing power parity is the idea that, in the long run, the same basket of goods should cost the same in two countries once prices are converted into one currency. This builds on the law of one price: identical tradable goods should have one price, otherwise traders would buy cheap and sell expensive. The absolute PPP rate is: PPP rate (quote per base) = price of basket in quote currency ÷ price of basket in base currency.
The valuation gap of the base currency = market rate ÷ PPP rate − 1. A negative value means the base currency is undervalued by PPP; a positive value means overvalued.
Relative PPP
Relative PPP says that the change in an exchange rate should reflect the difference in inflation: new PPP rate = old PPP rate × (1 + inflation of quote country) ÷ (1 + inflation of base country). The currency with higher inflation should lose value over time. Relative PPP is more useful in practice because it does not need identical baskets.
The real exchange rate
The real exchange rate adjusts the nominal rate for price levels: real rate = nominal rate × (price level of base country ÷ price level of quote country), usually as an index. If the real rate rises, the base currency buys more goods abroad than before; its exporters become less competitive.
Where PPP numbers come from
- The Economist's Big Mac index, published since 1986, uses one burger as a simple, light-hearted basket.
- International organisations such as the OECD (Organisation for Economic Co-operation and Development) and the World Bank publish PPP conversion factors for comparing economies.
Why PPP fails in the short run
- Many goods and services (rent, haircuts) are not traded across borders.
- Transport costs, taxes and tariffs differ.
- Exchange rates are driven mostly by capital flows, interest rates and risk appetite in the short run.
- The economist Kenneth Rogoff (1996) summarised research estimating that deviations from PPP take roughly three to five years to shrink by half. A currency can stay "cheap" for years.
Practical use: PPP is a long-term context tool. Strong overvaluation can be one reason to question a long-term trend or to reconsider an unhedged foreign investment, but it does not tell you when anything will happen.
Worked example
Hypothetical example: a basket costs €100 in the euro area and $115 in the USA. EUR/USD trades at 1.0500. Assumed annual inflation: USA 5%, euro area 2%. Taxes, quality differences and data revisions are ignored.
- Absolute PPP rate: 115 ÷ 100 = 1.1500 USD per EUR.
- Valuation gap of the euro: 1.0500 ÷ 1.1500 − 1 ≈ −8.7%. By this basket, the euro is undervalued.
- Relative PPP after one year: 1.1500 × 1.05 ÷ 1.02 ≈ 1.1838. After three years: 1.1500 × (1.05 ÷ 1.02)³ ≈ 1.2545.
- If EUR/USD is still 1.0500 after three years, the gap has widened: 1.0500 ÷ 1.2545 − 1 ≈ −16.3%. Higher US inflation has made the euro look cheaper, even though the market rate did not move.
Interpretation: the gap is information about long-term value, not a forecast. A trader who bought euros only because of the −8.7% gap could have waited years with no gain.
Common mistake
Practice activity
On paper: a basket costs ¥15,000 in Japan and $120 in the USA. USD/JPY trades at 150.00. (1) Calculate the PPP rate for USD/JPY. (2) Is the dollar over- or undervalued against the yen by this basket, and by how much? (3) If US inflation is 3% and Japanese inflation 1% next year, what is the new PPP rate?
Show solution
(1) PPP = 15,000 ÷ 120 = 125.00 yen per dollar.
(2) Gap of the dollar = 150.00 ÷ 125.00 − 1 = +20%. The dollar is overvalued by about 20% (the yen undervalued).
(3) The quote country is Japan: 125.00 × 1.01 ÷ 1.03 ≈ 122.57. Higher US inflation lowers the dollar's PPP value.
Limitations: one basket is a rough measure; official PPP estimates use broad baskets and are revised.
Key takeaways
- Absolute PPP compares basket prices; relative PPP adjusts exchange rates for inflation differences.
- Valuation gap = market rate ÷ PPP rate − 1; it shows over- or undervaluation of the base currency.
- Higher inflation lowers a currency's PPP value over time.
- PPP deviations can last for years; it is context, not timing.
Next step
In the next lesson you will measure correlations between currency pairs and use them to choose which pairs to watch.
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